Writing naked puts and how the financial sector makes so much money

In part the financial sector does the equivalent of writing "naked puts," namely taking risks which usually yield extra income but occasionally blow up and bring large losses, part of which are socialized.  Lending money to homeowners under relatively loose terms is one way of taking such a position but of course trading strategies can replicate related risk positions.

H. Peyton Young just wrote me that he and Dean Foster have a piece in the latest QJE on a closely related logic; I have yet to read it closely but it strikes me as a very very important article.

The key problem underlying all of this is we don't know how to punish people in a manner consistent with the rising size of absolute rewards.  As I wrote:

Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world.

That’s an underappreciated way to think about our modern, wealthy economy: Smart people have greater reach than ever before, and nothing really can go so wrong for them. As a broad-based portrait of the new world, that sounds pretty good, and usually it is. Just keep in mind that every now and then those smart people will be making—collectively—some pretty big mistakes.

Matt is correct that the argument doesn't require bailouts, although bailouts make the problem much worse, by neutering creditors as a risk-reducing force.

Most likely, shareholders favor some but not all of these "going short on volatility" risks.  To some extent they are ripping off the creditors by taking such risks, to some extent they are ripping off the public sector through an expected bailout (not true for most non-financial firms, of course), and to some extent the managers are pushing the risk beyond the point shareholders would desire, if they understood what was going on.  Keep in mind that shareholders and bondholders are also potential market competitors, so the firm's trading book can't be completely open to even the owners of the firm (a neglected point, in my view).

One question, raised by Robin Hanson, is why everyone doesn't write these naked puts.  You can introduce the "not everyone can expect a bailout" point here and it works fine.  But there are other reasons too:

1. Large-scale banking involves economies of scale (after the few biggest U.S. banks, size drops off dramatically).  You don't have to think these economies are socially productive; the point remains that Goldman can take positions which my local bank will not or cannot with equal facility, for a mix of institutional and expertise reasons.  The prospect of bailouts, of course, cements concentration in the sector because everyone wants to lend to "Too Big to Fail."

2. Arguably every bank does write the equivalent of naked puts to a socially non-optimal degree.  It is often homeowners on the other side of the market, arguably to an irrational degree.  In any case the resulting price of the put can be actuarially fair and the basic mechanism still operates.  If you play this strategy, you can expect (the mode) a bunch of years of multi-million returns, followed by an eventual unceremonious firing (if that) and life in the Hamptons.  If you follow an efficient markets strategy, you can expect the going rate of return on the diversified market portoflio.  Which sounds better?

Soon I'll write a post on whether vigilant creditors can neuter this risk-taking, so please hold off on that question for now.

Addendum: This "going short on volatility" risk strategy is receiving a good deal of attention from commentators on my piece, but I actually think "arriving there first with a good asset purchase," as I discuss in the article, is a somewhat more important mechanism for increasing income inequality among the top one percent.  A lot of the rise in income inequality has come outside the financial sector narrowly construed, though it still is related to the existence of relatively open capital markets.


This sort of reminds me of the old-style Lloyds insurance where 'names' received a cheque every year for putting up all their assets as collateral in case Lloyds needed to call on them to pay otherwise unfundable liabilities. It seemed like easy money for decades then 1988-1996 or so after massive asbestos etc liabilities huge claims were made on many 'names' with resulting bankruptcies and suicides.

Unlike the 'naked puts' that Tyler describes, these puts had a big downside. Maybe we need some liability regime like this for bank executives.

At these levels of wealth, people are seeking more money strictly for status. So hit 'em where it hurts by holding them up for ridicule.

Obama should just sign an executive order requiring that Goldman Sachs be called "Goldman Sucks" in all Federal Documents.

at last! this is, imho, the big question. Somehow engineering lower salaries and bonuses for bankers just increases bank profits if you hold revenues constant. I don't understand why so much attention is paid to banker pay when that is secondary to this question: why are bank revenues so high?

This isn't just about 'naked puts' - it's about fees, spreads etc. They make money all over the place. Why don't banks compete more on price? (I think T.E.D. has written about that).

After reading your essay on inequality and its pessimistic conclusion, I'm surprised this doesn't make you warm to Kotlikoff's LPB ideas. It's hard to see how banks could make out like bandits in that world.

The financial industry heartily approves of other industries taking steps to cut costs and improve efficiency, and we all know that productivity gains have the beneficial macroeconomic effect of cutting the real cost of goods and creating growth. What can we do to increase the productivity of the finance sector and cut its prices? If bankers got paid a fraction of what they do today, and revenues fell in tandem, that would be a tremendous increase in productivity for us all to benefit from. How can we bring it about? Assuming Kotlikoff's ideas have no hope of happening. How can we commoditise banking? How can we destroy their pricing power? I'd love to see much more effort directed at these questions.

[I'm interested in how the cash flows work. Ignoring activities that clearly generate a cash flow that matches profit (i.e. being paid a cash fee for handling a merger), and just thinking about making profits because the book price of some synthetic asset has risen (or whatever, forgive me if I'm not getting that quite right) bankers remove a lot of cash from the system in the form of salaries and cash bonuses, where does the cash come from?]

As always, the solution is to abolish fractional reserve banking.

Here's why the financial industry makes so much money: if I am working at a cash register at a store which for whatever reason sees billions of dollars pass through it every day, I would end up walking home with a whole lot of money regardless of what you thought you were paying me.

"not true for most non-financial firms, of course"

I would be very careful with such assertions. The history of bailouts is rife with non-financial firms: in our recent past we have General Motors and General Electric.

If Wal-Mart leveraged up to 20x and went bust next year, mightn't they receive a bailout? I would place relatively high odds on it.

What about Google? Exxon? Or any other super-large and super-important firm that has deep pockets and employs lots of people?

Furthermore, the lines are blurred now that "financial" firms can participate in nearly any type of business activity, either directly or indirectly.

The super-senior tranches that were held in such large size by some of the banks and AIG are as negatively skewed a payoff as is possible to construct in the financial markets. And they were a big part of the financial crisis as I discuss in an old post http://www.macroresilience.com/2009/11/06/a-ratio...
or a summary here http://www.macroresilience.com/2010/01/06/implica...

The role of moral hazard in enriching not just the banks but most actors in the financial markets is very hard to deny but a less oligopolistic banking sector would result in these rents flowing out to the broader economy which is the case in Germany for example http://www.macroresilience.com/2010/09/23/inequal... .

Capital requirements do theoretically solve the problem. When I ran a gold options book for a large swiss bank, our VAR (value at risk) calcs had me buying puts (mainly as I recall on palladium), and especially on friday afternoons, when a 3day VAR calc was required.

But that's only in theory.

Not only is the "size of the move" but the "time period" required for effective capital requirement calculations.

Further, the entire system benefits from more risk-taking with a bigger safety net being squeezed out of the government.

Soon, capital requirement calculations will be based on another set of Triple A ratings, no better than the last set.

The only thing that will work is NOTHING.

Stop bailing them out.

Let someone with a financial stake say, "I am not comfortable with my money here."

Writing naked puts you at risk of creating a crash blossom.

> It seemed like easy money for decades then 1988-1996 or so after massive asbestos etc liabilities huge claims were made on many 'names' with resulting bankruptcies and suicides.

Otto, one thing you're missing about Lloyd's was all the perverse incentives that lead to that disaster. For example, the reinsurance spiral (http://en.wikipedia.org/wiki/Reinsurance_spiral) meant that reserves were not built up.

And many of those bankruptcies and suicides were by people who had been brought in by Lloyd's specifically to pay for the asbestos claims that the insiders saw coming. The newbies were directed to the individual syndicates that would get hammered worst, while the old Names often simply monopolized the profitable and safe syndicates such as the nautical insurance syndicates. 'Recruit to dilute' as they said. (http://en.wikipedia.org/wiki/Lloyd%27s_of_London#.27Recruit_to_dilute.27)

So, unlimited liability is not a panacea.

The key problem underlying all of this is we don't know how to punish people in a manner consistent with the rising size of absolute rewards.

Actually, we do, but many object to the small cost to those who don't take risks they can afford, and those who take large risks they might not be able to afford object to being punished for doing so and winning, or worse escaping with a small loss and being punished.

Setting rules like capital requirements limit the risk to others while ensuring losses are punished, and then auditing to verify that the capital requirements were always met, and imposing penalties when the rules are violated, would prevent the "everyone does it" mindset from setting in.

Capital requirements are not inventions of government, but inventions of business people as means of ensuring contracts aren't one way bets. A builder seeks to make sure he'll get paid with an escrow account, and the customer will require the builder provide a bond.

Somehow, government regulation and enforcement of financial institutions and transactions has become a bad idea, but those who most strongly object don't call for eliminating all road rules like speed limits, or at least raising them substantially, and then calling for no police enforcement, until something bad happens. The speeding cars killing a bunch of school children does not result in people blaming the school zone speed limit laws and the concept of speed limits, as well as arguing for less police enforcement in the future.

Nor do people blame the dead children for failing to expect speeding cars that ignore the speed limit, the cross walk signs, and the crossing guard in the street.

Nor do people blame the insurers as causing the kids to cross the street according to the rules, or causing the drivers to speed because he's insured.

Nor do people argue the case should be dealt with a civil tort by the parents because the police can't properly enforce criminal law, law which is also too onerous when applied to all the responsible speeders who don't kill people.

Just as speed limits and other traffic rules are common sense laws, drawn from private experience, that require humans to interpret with significant judgement, financial regulation is common sense, drawn from private experience, requiring humans to interpret with significant judgement.

I think that lifetime bans from the financial industry would be appropriate for people who are found to misbehave in particular ways. The most obvious example is requiring a government bailout because your investment bank, bank or other financial concern is having balance sheet problems. Everyone on the board, all senior management and perhaps well below senior management in particular divisions that caused most of the firm's losses should be barred from ever again working in finance.

A reasonable objection would be that this would result in a world of finance where some of the most experienced personnel can no longer participate. I think that most of the people involved (especially the big losers) are highly replaceable and, once this becomes apparent, there may be many positive side effects.

I think this is perhaps missing the point. BANKS don't make a particularly exceptional amount of money - they provide a pretty good return on equity capital, but not outlandishly so compared to other growth industries over the past decade - and finance has certainly been a growth industry.

BANKERS make a ton of money. The reason for this, in my view, is that the industry is so scalable. There are plenty of hedge funds with a billion or more in effective equity capital (say at a conservative valuation around 8-10% of AUM), that employ only a handful of people. The profitability is perhaps not very high, but the profit/worker is enormous, which leads to the extreme income levels of the employees.

All workers at every firm generally benefit from the socialization of losses - you can't pay employees less than zero even when the firm loses money. But in no other industry can a tiny group of workers effectively manage a billion or more dollars of capital.

The loss socialization issue doesn't seem significant to me for two reasons: (1) if no loss socialization had been contemplated (i.e. equity and debt holders had just taken the hit), bankers would still have been enormously well compensated compared to other professions over any meaningful period of time. The significant loss socialization has nothing to do with the bailouts, it has to do with the fact that in banking, like every other industry, money-losing firms can't go back and take money previously paid to employees. (2) There seems to be no correlation between the degree of loss socialization at the firm level and compensation. Bankers at firms whose losses are fully socialized (RBS/Bank of America) do just as well as those at firms with no loss socialization (hedge funds/private equity). But again, at both types of firm, there's no way to go get money back when the firm's profitability goes negative.

This doesn't explain why bankers make more money now than in 1970. I reject a lot of the specifics, too.

Tyler - Good to see you finally read Taleb's Black Swan book.

Also, to expand on Chris' excellent points above, the ROE at investment banks isn't so hot, and shareholder returns haven't exactly been all great either. The real question is: why do some of the employees get paid so much?

First and foremost: it is supply and demand. If I want to hire a successful derivatives trader with 5 to 7 years experience, I've got to pay perhaps $800,000 to $1 million a year for them. That's the market, and a pretty well calibrated one, in my experience. There is a lot of demand for those skills, and limited supply. Or I can pay less for someone, with less skills.

"I think that lifetime bans from the financial industry would be appropriate ... because your investment bank, bank or other financial concern is having balance sheet problems."

Interesting idea. On the other hand, would that just exacerbate get-rich-quickitis? "We got to make a killing this year cuz we might get banned for life next year!"

Prison doesn't have that problem.

dirk, the difference is you aren't inventing the products you're selling. Invesmtent ideas are proprietary and subject to most intense competition. Relationship managers for term bank loans aren't making 2% either. But farbeit from me to get in the way of your populist rant- you tell those Ivy League bastards.

To Dirk, it's entirely possible that Wall Street will decide that Penn State grads - or high school grads, or cavemen - are generally just as talented than Harvard or MIT grads. I don't expect that in and of itself to change the compensation structure. As long as you believe that there is any measurable differentiation among specific employees, there will be huge amounts of pay, because that tiny incremental difference in quality represents a massive amount of dollars when applied to the gargantuan bases of capital our financial sector possesses - and employees will continue to be effective at recovering the extra value they are thought to produce. Only a regime that basically makes any responsible employee roughly identical - say the heavily regulated brokerage regime of a few decades ago - will keep salaries in line.

As for "sabermetrics", it's a nice thought, but I think the sample sizes are unlikely to become large and diverse enough for that sort of analysis to be truly meaningful. If a baseball player looks great for 10 seasons in a row, it probably means he's pretty damn good. A trader who puts up great results for 10 straight years could just be selling short some massive tail risk that's lurking, waiting to explode.

What I do *NOT* believe, today, is that the "financial system" would have stopped performing if, instead of TARP, there had been bankruptcy for the insolvent/ illequid firms.

The Fed could have done whatever is "needed" in the "financial system", while all the Big Banks went thru bankruptcy -- wipe out equity, end all bonuses for all execs, fire most execs, big or total wipe out bondholders, debt to equity new capitalization of new firms.

What Main Street needs from the financial system is loans, for new projects. Had the Fed concentrated on Main Street, letting the banks & their lawyers & rocket scientists live without bailouts, and lose BIG from their reckless lending, including Goldman when AIG goes under and they become debt-owners of new post-bankrupt AIG, this would have been a better result than what we have.

It is a gov't job to provide the rules and procedures for bankruptcy, when Legal Fictions are unable to fulfill their contractual obligations. The gov't failed, hugely, and instead shoveled tax cash to hide the failures.

Long Term Capital Management should have been allowed to go belly up, too, and be used by the Fed/ Treasury to learn how allow big irresponsible firms (with multiple Nobel Prize Economists!) to die without taking down Main Street.

The huge compensation for financial folks is OK when their losses are not socialized. Given that the losses have been, and will be, socialized, the compensation is way out of line. $1 tril every ten years is probably much more than $1 bln every year per TARP receiving firm, but that seems like one reasonable proposal.

I'd prefer higher taxes on all "systemically important" firms, to the point where their top earners prefer to leave and start their own boutiques taking the cream customers until none of them are systemically important. That could mean a revenue surtax on financial firms over some amount (?10 bln), that is highly progressive and even punitive.

Justice requires more punitive action than has so far been taken.

Can I make a suggestion? I believe youve obtained one thing good here. But what for those who added a pair links to a page that backs up what youre saying? Or maybe you might give us something to have a look at, something that might connect what youre saying to something tangible? Just a suggestion. Anyway, in my language, there are usually not much good source like this.

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